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short essays and reports on the economic issues of the day
2007 ■ Number 15

Inflation Disconnect?
Riccardo DiCecio
eadline inflation is the percentage change in the price
not be reasonable to conclude that monetary policy has been
index for a basket of goods and services. Core inflation
effective in maintaining price stability by looking solely at a core
measures the underlying trend in inflation, i.e., the commeasure of inflation that excludes sustained oil price increases.
ponent of inflation most closely linked to monetary policy actions
However, one must keep in mind that an increase in energy prices
in the longer term. The most common way to measure core inflacould present monetary policymakers with a trade-off between
tion is to exclude food and energy from the set of goods and
controlling inflation and stabilizing the output gap (i.e., the differservices. The rationale for excluding food and energy prices is
ence between actual and potential output) if these price increases
that historically they have been highly volatile and high volatility
affect actual output more than potential. The optimal resolution
tends to mask the underlying inflation trend. But why always
of this trade-off is an active area of research.3
exclude these two classes of goods while including others?
In sum, price indices provide a snapshot of the dynamics of
The difference between headline inflation and the most comprices of a basket of goods and services. However, because each
monly used measure of core inflation (less food and energy, or
core index suppresses a different source of information, they each
XFE in short) has been increasing since early 2004, for both
provide a different measure of inflation. Especially in times of
consumer price index (CPI) inflation and personal consumption
substantial relative price movements, all price indices should be
expenditures (PCE) inflation. The gray line in the chart illustrates
considered by policymakers and analysts. ■
this by showing a 5-year moving average of the difference between
1 Mick Silver, “Core Inflation Measures and Statistical Issues in Choosing Among
headline CPI inflation and CPI-XFE inflation. The discrepancy
Them,” Working Paper No. 06/97, International Monetary Fund, April 2006.
between these two indices reflects the sharp and sustained increase
2 Kristie M. Engemann and Michael T. Owyang, “Hard ‘Core’ Inflation,” Federal
in the price of oil between mid-2004 and mid-2006. The inflation
Reserve Bank of St. Louis Monetary Trends, February 2005.
rate of the energy component of the CPI (CPI-E) has been grow3 For a comprehensive review of this literature, see Lutz Kilian, “The Economic
ing much faster than the overall CPI. (The blue line in the chart
Effects of Energy Price Shocks,” Journal of Economic Literature, forthcoming.
shows the difference between the two.)
The academic literature is increasingly focused on
limited-influence estimators to measure core inflation.1
CPI Inflation Rates: Headline, Core Measures, and Energy
In fact, the Federal Reserve Bank of Cleveland calcu(5-year moving averages of annualized % change)
lates two such monthly measures of core inflation: the
Energy Inflation
Monthly Headline Inflation
weighted median2 and the trimmed mean CPI inflation
minus Headline Inflation
minus Core Inflation
rates. These measures exclude the items facing more
CPI-E minus CPI
extreme price movements in each time period, resulting
(right axis)
in a different basket of omitted items each period.
Proponents have argued that limited-influence meas0.5
ures of core inflation have superior statistical properties
and, in particular, are better at forecasting headline infla0.0
tion. The black line in the chart shows the difference
between headline inflation and core inflation, measured
by the 16 percent trimmed mean CPI inflation (CPICPI minus CPI-TMI
(left axis)
TMI). This smaller difference between core and headline
inflation suggests that discrepancies between headline
(left axis)
and core inflation are partly induced by the way core
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
inflation is defined and measured.
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
A disconnect between measures of headline and core
SOURCE: Bureau of Labor Statistics; Federal Reserve Bank of Cleveland; Haver.
inflation could be a concern for policymakers: It may


Views expressed do not necessarily reflect official positions of the Federal Reserve System.